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GM Is On Track

Even with our lower fair value estimate, the dividend payer looks attractive.

When

In addition, we reduced our European revenue growth outlook for 2015 versus 2014 to 3% from 10%. We no longer consider 10% growth likely, given GM Europe's small-car push this year and major uncertainty in Russia. We also changed our 2015 revenue growth forecast for the GM international operations segment to a 1% decline from 5% growth as a result of new guidance for flat volume and pricing. These changes reduced our fair value estimate to $48 per share from $53. Despite this reduction, we continue to think that GM's investment thesis is one of the most compelling in our auto coverage, and the stock remains significantly undervalued while paying a 3.5% dividend yield.

Management expects all regions to increase automotive-adjusted EBIT and adjusted EBIT margins relative to 2014, even after excluding about $2.5 billion in 2014 recall charges. GM expects favorable mix and pricing to boost results relative to last year, thanks to new product launches, especially crossovers and SUVs in markets such as the Middle East and China. Europe's mix will be a headwind due to new small-car launches such as the Corsa, but that should be more than offset by volume increases, new product pricing, and lower restructuring charges in 2015 now that the Bochum plant is closed. GM indicated its restructuring for 2015 will be about $700 million, but cash restructuring will be about $1 billion to reflect payments for some items booked in 2014.

Excellent Earnings Potential We think GM's car models are of the best quality and design in decades. The company is already a leader in truck models, so a competitive lineup in all segments, combined with a much smaller cost base, leads us to think that GM will be increasing profits as vehicle demand recovers.

We think earnings potential is excellent because GM finally has a healthy North American unit and can focus its U.S. marketing efforts on just four brands instead of eight. The most critical cost-saving measure was setting up a voluntary employees' beneficiary association for the retiree health-care costs of the United Auto Workers. This saves GM about $3 billion a year; other benefit concessions and plant closings have drastically lowered GM North America's break-even point to U.S. industry sales of about 10.5 million vehicles, assuming 18%-19% share. The actual point varies based on mix and incentive levels. We think the normative demand for U.S. light vehicles is about 16.4 million-18.3 million units, so we expect GM to report excellent earnings growth as vehicle demand comes back during the next few years. We expect further scale to come from GM moving its production to 99% on global platforms by 2020 from just 39% in 2010 and from GM being in one of its largest new product rollouts ever.

Dramatically better pricing has helped GM to be profitable at volume levels that would have meant billions in losses a few years ago. For example, the Cadillac CTS sells for as much as $8,000 more than the prior-generation CTS, and pricing will also be helped by the 2014 Chevrolet Impala receiving Consumer Reports' highest score of any sedan and being compared to a luxury vehicle. Simply put, GM makes products that consumers are willing to pay more for than in the past. It no longer has to overproduce in an attempt to cover high labor costs and then dump cars into rental fleets (which hurts residual values). It now operates in a demand-pull model where it can produce only to meet demand, is structured to break even at the bottom of an economic cycle, and is about to see the upside to having a high degree of operating leverage.

Competition and Cyclicality Prevent Moat GM does not have a moat, and we do not expect that to change. Vehicle manufacturing is a very capital-intensive business, but barriers to entry are not as high as in the past. As the global vehicle market expands, a new firm only needs to get a small piece of the market in order to generate enough revenue to make the large investment in a factory worthwhile. The industry is already full of strong competition, so it is nearly impossible for one firm to gain a sustainable advantage. Automakers from China and India may soon enter developed markets such as the United States, and South Korea's Hyundai has become a formidable competitor. Furthermore, the auto industry is so cyclical that in bad times even the best automakers cannot avoid large declines in return on invested capital and profit. Cost-cutting helps ease the pain, but it does not restore all lost profit.

Prolonged Sales Decline, Recalls Present Risk One of the biggest risks to GM is too many Americans refusing to buy its vehicles because of animosity over the taxpayer-financed bailout or its recall woes. If sales were to decline for many years, GM probably would go bankrupt. We consider the likelihood of this scenario to be nearly zero. GM can break even at near-depression-like sales volume. Another important risk is GM's underfunded pension. The plan was underfunded by $19.9 billion as of Dec. 31, 2013. In late 2010, GM contributed $4 billion in cash to the pension and an additional $2.2 billion in GM common stock in January 2011. Management does not expect to be forced to make any contributions to the U.S. qualified plan for at least five years, but that assertion is only an estimate. U.S. gas prices going well over $4 a gallon is also a risk, as GM recently unveiled a new generation of full-size pickup trucks and SUVs, its most profitable vehicles. However, those products appear very well timed with gas prices falling.

The $7 billion recall reserve is our very conservative estimate of Justice Department fines, the victims fund, Securities and Exchange Commission fines, and other litigation such as loss of resale value. We suspect that our $7 billion estimate will prove to be far too high, but we would rather over-reserve than be too low and have to reduce our fair value estimate again later.

Our fair value estimate could change dramatically, given the extreme sensitivity of our discounted cash flow model to key inputs such as North American light-vehicle sales, midcycle margin, and the weighted average cost of capital. Our fair value uncertainty is high to account for the wide possibilities in GM's fair value estimate, given its high degree of operating leverage.

Capital Allocation in Question GM's capital allocation history is short but already mixed. Returns on invested capital had been below the weighted average cost of capital until 2012, but we expect healthy economic profit during our forecast period. The concern we--and a lot of investors--have is what GM will do with its cash hoard. We would like to see a combination of voluntary pension funding and common stock repurchases, since the shares trade far below our fair value estimate. We were pleased with GM's December 2012 announcement to repurchase 200 million of the U.S. Treasury's 500.1 million shares because the stock was trading well below our fair value estimate then, too. Cash payments to the pension would also alleviate a major overhang on the stock. Investors have been hoping for news like buybacks or pension funding, and we think the market was disappointed to instead see GM buy 7% of Peugeot, which it then sold in late 2013. However, the January 2014 initiation of a respectable-size dividend is a step in the right direction. We do not expect a buyback or a dividend increase in 2015, given recall litigation and possible government fines looming.

With the U.S. Treasury no longer owning GM's stock, we expect the Canadian government to exit soon. We were encouraged to see the Canadian government begin selling its common shares in September 2013 down to about 110.1 million shares. We also expect the VEBA to reduce its stake over time because it needs to monetize its holdings to pay retiree health-care claims. Although concerns about these stakeholders are valid, we see them as short-term issues that will be resolved. We think a patient GM shareholder eventually will be rewarded, as the company is about to see the upside to having a high degree of operating leverage.

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